Capital Gains

For a while now, I've thought that the current capital gains tax system is completely messed up. This is based on personal experience of trying to manage my stock portfolio as well as theoretical thinking about what the tax code is trying to achieve.

The biggest problem, in my mind, with the current system is the "cliffs" that occur at 1 year (and previously occured at 5 years). Under the new rules for 2003 (actually just after May 5, 2003 which is it's own little nightmare for reporting) the rate for "short-term" gains (held under one year) is your normal income tax rate. The rate for "long-term" gains (held one year or longer) is 15% (for people above the 15% income tax bracket) or 5% (for people in the 15% tax bracket). The 2003 changes also repealed the "super-long-term" category for assets held over 5 years.

Now personally, this has always been a pain in the ass when it comes to selling stock because you have the situation (and this has happened to me several times) where holding on to the stock one or two weeks more will drastically lower your taxes, but it doesn't fit in to your investment strategy (e.g. you think the stock could drop in the near term) or your liquidity needs (e.g. you need the money to put a downpayment on a house).

Theoretically, I understand that the cliff is supposed to encourage long-term saving and discourage speculation. It's arguable whether these incentives need to be there – free-marketers would argue that they distort the market and limit healthy arbitrage. But, in a post-Enron world, there's more support for regulations that discourage quick profit-taking and encourage the long view. (And there actually are some findings from behavioral economics that humans have non-exponential discount functions and might need encouragement to be more "rational".) So, for the purposes of this post, I'll assume that the long-term incentive is desirable.

In light of these facts, I have a new proposal...

Instead of a "cliff" system, with multiple rates to add progressivity, we should move to one formula that provides a continuous tax function. My proposed function would be:

             (gain on asset sale) * (marginal income tax rate) * 365
  tax owed = ----------------------------------------------------------------
                                  A * (days asset owned) + 365

Here the marginal income tax rate would be calculated based on your adjusted gross income as if the capital gains were included as regular income. This is the same method that is currently used to determine whether you fit in the 15% bracket or not. A is an accelerator that could be modified by law to determine how fast the rate decreased over time.

While it seems a bit more daunting, here are the advantages that I see:

1. There is a simple place to adjust the speed at which the tax rate declines. For example, with A set to 1.0, the rate after one year would be half the nominal rate. A = 2.0 would make it one third the nominal rate, and A = 0.5 would make it two thirds.
2. There are no cliffs in the system. Your tax rate on the capital gains goes down steadily from day one. In addition, the incentive stays in place after year one, so there is a (diminished, but still real) incentive even for assets held for 2 or 3 years. (For instance, if A = 1.0 the tax rate would drop from one third your marginal rate to one quarter.)
3. It's automatically as progressive as the tax code is. Since the rate is based on the taxpayer's marginal income tax rate, there's no need for different rules and arbitrary buckets (e.g. above 15% bracket and below).
4. Although the formula is more complicated, the data required to calculate the rate is the same as the current method. You need purchase date, purchase amount, sale date, and sale amount.

Potentially, there could be options involved to ease the filings of lower income people. For instance, you should always have the option to just treat the gain as ordinary income, and perhaps there should be an income threshold or a perentage of capital gains to ordinary income under which you wouldn't need to file a Schedule D. In addition, tables could be provided that approximated the formula for people below certain income levels. But, particularly given the complexity of the 2003 return with the cut-off date, etc., this doesn't seem drastically more difficult than the current April 15 nightmare.

In general, I'm opposed to social engineering through the tax code – at least the income tax that goes into the general revenue account. Usually, externalities that the government is trying to internalize in the market should be handled through more targeted user fees, etc. But if we're going to have a system that progressively tax capital gains while encouraging long-term planning, this seems to make more sense to me than the current system.

Comments? Too complicated? Bad idea? Things I haven't thought about?